​​​​​​The pandemic may not have killed fintech, but inflation still could.

The resulting hike in interest rates—particularly in the US, where the Federal Reserve this week announced a further rise of 75 basis points—has negatively affected equity investments, and particularly tech firms. This year the S&P 500 has fallen by 20% and the Nasdaq by 25%, while shares in recently listed fintechs have dropped by 50%.

Technology intelligence firm CB Insights says fintech businesses raised $20.4 billion in Q2—a 33% drop on Q1 and the lowest quarterly level since Q4 2020. The problems are especially acute for start-ups, which raise six to 12 months of “burn”—cash for operating expenses—before going back to investors, often when they can command higher valuations. The earnings they might generate when their products reach the market are currently less appealing when discounted against higher risk-free rates.

With their traditional backers in venture capital pulling back, fintechs are facing a funding crunch. Yet these businesses may also offer opportunities for banks looking to boost their tech credentials by making strategic investments in the sector.

Jezri Mohideen, wholesale chief digital officer and co-head of global markets for Europe, the Middle East and Africa at Nomura, says: “There’s no question that higher rates are starting to have an effect on fintechs. Funding models have been very friendly, but the next 12 months will be challenging. A lot of fintechs will have cashflow issues and fundraising pressure.”

Bimal Kadikar, CEO at Transcend Street Solutions—which helps financial institutions optimise their funding, collateral and liquidity—agrees that the funding landscape has changed rapidly: “Whether it’s inflation, rising rates or the realisation that multiples are unsustainable, financing is definitely now significantly slowed.”

The underlying sentiment was echoed in the views expressed by fintech investors, who think companies will need to ensure that the “easy” money raised at 2021 pricing levels lasts far longer than the businesses had been expecting. Mohideen says early-stage fintechs will now need around 18 to 24 months of burn: “Then, if they can see through the higher rates, maybe the slowdown will allow them to grab market share.”

Mark Beeston, founder of Illuminate Financial Management, a financial markets technology-focused VC firm, says: “The ‘let’s raise now at high levels, burn aggressively to grow, but don’t worry, we’ll just back up the truck and raise some more money at fantastic market levels in 12 months’ time’ model—that party is clearly over.”

“We’ll see people sweeping up technology assets into single vehicles,” says Stuart McClymont, CEO of market infrastructure at consultant Delta Capita. “That consolidation may be driven by firms running out of money. And because they’re running out of money, they are cheaper to acquire.”

Mohideen says Nomura is looking at distressed entities as investment opportunities and asking: “Is it worth acquiring their tech or people, as opposed to us trying to build it?” He adds that the new macro environment makes it easier to negotiate with fintechs: “They need us more than we need them.”

From going concerns to growing concerns

In 2018, WatersTechnology sibling publication Risk.net reported that one of the main fears among budding risktechs was that they might not be able to hold on long enough for their products to pay off. That fear is now intensifying.

Machine learning fintech Cardabel says it has accumulated enough burn to sustain its activities for two years, even if revenue drops to zero—but only if its operating expenses remain “conservative”. The business has six clients, including Crédit Agricole custodian Caceis, for which it has implemented a supervised machine learning model to reconcile financial transactions.

Cardabel is self-funded and has no VC investment. It is not currently looking for new money and does not want to be dependent on VCs. Its CEO Lionel Simon says: “In this coming year, I don’t know how a VC would react and what constraint they would put on their funds.”

High inflation creates another dilemma for the company. “The issue for us is more what do we do with the cash we keep as a cushion for bad times in this crisis time?” says Simon. “It’s a challenge to invest cash when you add in inflation, which is 8% in Europe.”

Transcend started out as self-funded before amassing around $10 million in 2020 through a Series A fundraising with VC firm Nyca Partners. Kadikar says the things that made fintechs attractive to VCs—the latter’s need to secure growth at any cost—are less enticing in the current environment, where there are other factors in play, such as “burn and sustainability, and how long can you go”.

Four of the other fintechs we profiled have since been acquired by bigger firms. Blockchain start-up Firmo Network was absorbed by social trading network eToro’s cryptocurrency arm. Compliance technology specialist Governor Software was bought out by MyComplianceOffice. Regulatory reporting provider RegTek.Solutions, which received Series A funding from Deutsche Börse and Illuminate Financial Management in 2017, was acquired by Bloomberg.

Percentile, a provider of cloud-based risk technology, was snapped up by post-trade player Torstone Technology. Brian Collings, CEO at Torstone, says Percentile “tried to get some traction, but was a pretty small company. As a start-up with four people, they were paying themselves practically nothing, sweat equity, without any sort of external funding.”

Asked if Torstone—which has grown organically—has been affected by rising interest rates, Collings says the volatility of the market has been positive because it has generated more trading activity and led clients to upgrade their processes.

The other nine fintechs we profiled did not respond to requests for comment on the potential effects of rising rates on their business models.

Down but not out

Some start-ups have a similar perspective to Torstone and perceive opportunities amid the current adversity. Jack Hidary, chief executive of quantum technology company Sandbox AQ, a spinoff from Google’s parent Alphabet, is a serial entrepreneur. “I’ve built companies through at least three such periods before,” he says. “These can be productive times when you’re focused on the product and the customers.” He thinks fintech investments will be insulated because of drivers, such as regulatory imperatives, that other sectors may lack.

Nevertheless, some privately held fintechs are doing worse than the sector as a whole. Klarna had its valuation slashed from $46 billion to less than $7 billion in a funding round that was completed this month.

Transcend’s Kadikar reckons fintechs’ multiples—how much investors are willing to pay in relation to earnings—have dropped by 50–70% since last year. VCs have been hit hard by macroeconomic conditions and the collapse in fintech valuations, and are finding it difficult to secure funding to prop up companies into which they have already poured hundreds of billions.

“At face value it should be a fantastic moment for private funds to go out and raise capital because they’re no longer competing with these artificially inflated public equity returns,” says Beeston. However, he says that although VC investments typically target double-digit returns, they are locked into illiquid vehicles that in recent months have looked historically less attractive than the liquid public markets—the valuations and returns of which were fuelled by cheap money during the bull run that followed the global financial crisis.

Beeston points out that because the share of their portfolios invested in public markets has fallen, many investors are now overweight in private markets. As such, more capital will not automatically be driven to private markets, even though that source of competition has been eroded.

Banks are not necessarily feeling the same funding pressures as VCs. Some sniff an opportunity to swoop in and acquire cash-strapped fintechs on the cheap. Mohideen says Nomura is not expecting a slowdown in its own business and, if anything, the volatile interest rates will benefit trading: “There is more activity, more client hedging, and volatility creates opportunity.”

Matthieu Soulé, head of C.Lab Americas, BNP Paribas’s innovation lab in San Francisco, also sees the potential upside from the current macroeconomic picture: “Volatility in market valuations is creating opportunities for investors willing to take risks, meaning some investors could receive discounts. The same company they could have invested in six months ago is now valued differently.”

He cautions that economic woes could create risks in areas such as lending. However, he adds that wider shifts towards digital payments or online banking are well established, so the outlook for fintechs as well as incumbent banks is “booming”.

Nomura’s Mohideen says the bank will be picky. He sees “decent” opportunities for fintechs operating electronic infrastructure for trading, data platforms for model back-testing and on-the-fly risk calculations. However, he believes that employing natural language processing to derive “wisdom of the crowd-type data for alpha generation” has not delivered significant benefits, and that the start-ups pursuing this may suffer in the current macro environment.

Other banks think inflation and rising rates will be more of a concern for VCs, whose business models and expectations differ from their own. These banks say their own investments are driven by fundamental and strategic priorities: the pandemic, for example, pushed banks into remote working, which in turn led them to radically rethink their approaches to technology. The head of digital at a tier one bank says: “Our expectation of our principal investments is around the strategic value they bring to our businesses, so we have a more long-term horizon.”

As a VC, Illuminate’s Beeston is also maintaining a long-term outlook. He does not think the rise in interest rates fundamentally changes the situation for VC, which will still be targeting double-digit returns rather than returns relative to another market or benchmark. However, investors do not always see it the same way. “The anti-inflation measures being taken in monetary policy, and the impact on public equities as an observable and referenceable asset class, do indeed have a potentially significant impact on the venture space,” he says.

The new macroeconomic “normal” could still bury some fintech start-ups. Yet it may also provide a boost to businesses with the right propositions and enough cash to survive today’s challenging fundraising environment.

Correction, August 1, 2022: This article has been amended to correctly illustrate the link between the decline in public markets and the rise in the share of private holdings within investors’ portfolios.